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• Inflation Threat: Causes, Components And Cover
• This Cash Flow Machine Offers A Stable 8.6% Dividend Yield

• EPB 0% Rate It
• EPD 100% Rate It
• ETP 100% Rate It
• KMP 50% Rate It
• PAA 100% Rate It

My prior articles focused on master limited partnerships ("MLPs"), an area I have long followed and invested in. My concern with overly concentrating my portfolio in MLPs has led me to examine mortgage Real Estate Investment Trusts ("mREITs") as an alternative yield producing vehicle. Indeed, the current dividend yields on some mREITs exceed the distribution yields on many MLPs including El Paso Pipeline Partners ( EPB ), Enterprise Products Partners ( EPD ), Energy Transfer Partners ( ETP ), Kinder Morgan Energy Partners ( KMP ), Plains All American Pipeline ( PAA ), and Williams Partners (WPZ).

I have been evaluating Annaly Capital Management, Inc. (NLY) and American Capital Agency Corp. (AGNC). This report focuses on NLY, the largest mREIT listed on the NYSE with a market cap of ~$16.7 billion and assets on the balance sheet as of 6/30/12 totaling ~$128 billion. NYL owns, manages, and finances a portfolio of real estate related investments, including mortgage pass-through certificates, collateralized mortgage obligations ("CMOs"), callable debentures and other securities backed by pools of mortgage loans.

Total returns generated through 8/24/12 (based on the $17.16 closing price) are summarized in Table 1 below:

Table 1

Past returns appear to be attractive and the current yield is enticing at 12.8%. However, investors familiar with my approach know the first question I ask is what portion, if any, of the dividends I am receiving are really "earned". I am leery of investing in entities (publicly traded partnerships or companies) that pay dividends, or fund distributions, by issuing debt or additional equity. In taking a closer look at NLY I encountered difficulties similar to those I faced when reviewing the performance of MLPs. Since money is fungible and the NLY annual report runs over 100 pages that are frequently hard to understand, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.

Several examples can illustrate the complexities. The bulk of NLY's assets consist of mortgage-backed securities and debentures issued by Fannie Mae, Freddie Mac or Ginnie Mae, and of corporate debt (together, "Investment Securities"). These are classified for accounting purposes as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. The effect can be dramatic, as seen in 3Q 2011 when reported losses (realized and unrealized) amounted to 38.8% of the average equity and NLY's net loss for the period amounted to ~$926 million. But there were $1.1 billion of unrealized gains in that quarter that showed up only on the balance sheet, not the income statement. Another example is the subjectivity involved in determining net interest margin, an important performance indicator. Beginning June 30, 2011, NLY reclassified "interest expense on swaps" to "realized gains (losses) on swaps" thus changing the way net interest margin is calculated, Therefore, I find NLY's net interest margins, reported earnings, earnings per share and earnings multiples to be of limited value as indicators of performance or of ability to generate sustainable dividends.

The treatment of borrowing and lending via repurchase and reverse repurchase agreements ("repos") is yet another example. NLY reports cash flow from these activities as cash flows from operating activities when they are performed by RCap (NLY's wholly owned broker-dealer subsidiary), but when they are not performed by RCap, they appear as cash flow from investing activities. Therefore I find NLY's distinctions between the various categories on the cash flow statement (i.e., operations, investments and financing) to be of limited value in understanding NLY's ability to generate sustainable dividends.

In light of these issues, I developed my own definition of distributable cash flow ("DCF"), thus creating a quantitative standard that I view as an indicator of NLY's ability to generate cash flow at a level that can sustain or support an increase in quarterly distribution rates. The definition is relatively simple: net income + amortization (a non-cash item), + losses (or minus gains) on assets & liabilities (also non-cash items), less cash used for working capital. The results for the past 4 years are outlined in Table 2 below:

Table 2: Figures in $ Millions except coverage ratios

Results for 2Q 2012, 2Q 2011, the first half of 2012 and of 2011 (1H12 and 1H11) are outlined in Table 3 below:

Table 3: Figures in $ Millions except coverage ratios

Losses (gains) on assets and liabilities in Tables 2 and 3 are comprised of realized and unrealized gains and losses on mortgage backed securities, debentures, equity securities, interest rate swaps. The losses and gains are added and subtracted, respectively, because they are non-cash items.

As part of my analysis, I also created a simplified cash flow statement designed to shed light on the sustainability of the dividends by, for example, grouping together and netting out numerous line items that deal with gains and losses that are reported in the income statement but are non-cash items (and therefore reversed out in the cash flow statement). I also separate cash generation from cash consumption and group together and net out numerous line items that deal with cash outflows for assets (e.g., acquiring assets outright or receiving assets as collateral and lending against them) and cash generated by assets (e.g., selling assets outright or giving assets as collateral and borrowing against them). This reduces the over 50 line items in NLY's cash flow statement to just a few. Results for the past 4 years are outlined in Table 4 below:

Simplified Cash Flow Statement:

Table 4: Figures in $ Millions

In these simplified cash flow statements proceeds from, and payments for, assets contain numerous types of netted items, including: a) repos and reverse repos; b) securities borrowed and loaned; c) securities purchased and sold; d) principal payments on, or maturities of, securities owned; e) equity investments (including investments in affiliates). Of course, the net increase (decrease) in cash and cash equivalents ties to the company's financial statements.

Results for 2Q 2012, 2Q 2011, 1H12 and 1H11 are outlined in Table 5:

Table 5: Figures in $ Millions

Roughly speaking, on a net basis over the 4-year period of 2008-2011, NLY generated ~$8 billion, raised a further $10.1 billion via equity and debt (of which only $0.6 billion from debt via issuance of senior convertible notes) and used the total of $18.1 billion to increase its portfolio ($12.2 billion) and to pay dividends ($5.9 billion).

For the 6-month period ending 6/30/12, NLY generated ~$1.5 billion, raised ~ $1 billion via issuance of senior notes and preferred shares, and generated ~$182 million by reducing working capital (including cash balances). It used the total of $2.7 billion to increase its portfolio (~$1.6 billion) and to pay dividends (~$1.1 billion).

NLY continues to demonstrate an ability to generate cash sufficient to both fund dividends and supplement funds raised via issuance of equity and debt in order to increase the size of the investment portfolio.

Clearly the 12.8% yield does not come without risks and past performance may not be a good indicator of future performance. NLY has benefited from the accommodative stance of the Federal Reserve Bank which, for the past several years, has resulted in a relatively steep yield curve, albeit at low absolute rates. The shape of yield curve and amount of leverage (the bulk of which is generated via the repurchase markets) are the key drivers of return for NLY which relies primarily on short-term borrowings to acquire Investment Securities with long-term maturities. Accordingly, profitability may be adversely affected if short-term interest rates increase or if the spread narrows. NLY's Form 10-K lists numerous other risks, including the health of its Chairman, CEO and President.

I look at several risk and performance parameters:

Leverage : Management has been keeping leverage at the low end of its 8 to 12 leverage band since 2007. Reduced leverage reduces both interest rate risk and systemic risk (e.g., crisis in Europe, regulatory pressures for mortgage finance reform, future of Freddie Mac & Fannie Mae, SEC review of the exemption granted to mortgage REITs from the 1940 Act which would cause them to be considered as mutual funds). However, in 2012 leverage has increased:

Sensitivity to changes in interest rates : data provided by management is outlined in Table 6 below. It indicates a limited exposure to changes in interest rates as of 6/30/12:

1. Assuming movement is in the entire yield curve
2. . Including interest expense on interest rate swaps

Table 6

However, this may not be a reliable indication of exposure to changes in interest rates for two major reasons: first, the assumption that the entire yield curve moves in tandem is not as bad a scenario for NLY as a further flattening (to say nothing of inversion) of the curve. Second, management's estimates speed of prepayment vary at each interest rate level and we have no way of knowing how conservative or aggressive these assumptions are.

Prepayment speeds as reflected by the Constant Prepayment Rate ("CPR"): In the aggregate, mortgage backed securities purchased by NLY at a premium exceed those it purchased at a discount. Therefore, the faster the prepayment rate the greater the loss. While CPR rates have increased significantly vs. 6/30/11, they appear to be leveling off:

Duration: as of 12/31/11 duration was at a short 1.2 years. Duration is the length of time required to recoup losses caused by a percent increase in short and long-term interest rates (losses are recouped by reinvesting at higher interest rates). Giving effect to swap transactions, NLY reported average duration (0.4) years as of 12/31/11. The negative number indicates that, giving effect to swap transactions, the duration of NLY's assets is shorter than that of its liabilities. An update as of 6/30/12 was not provided.

Net interest spread: data provided by management indicates net interest spread has been declining since 6/30/11:

Management seeks to mitigate the effect of changes in interest rates by matching adjustable rate assets with variable rate borrowings and therefore swaps its fixed rate liabilities via agreements whereby it receives fixed rate payments and makes floating rate payments. Management noted in the its 2Q12 report that the weighted average rate it pays rate on these interest swaps will continue to decline "…for the immediately foreseeable periods…" as a result of interest rate swaps with higher pay rates maturing or being terminated and the replacement of such swaps with interest rate swaps with lower pay rates.

Book value per share:

In summary, the bulk of investor returns have come from dividends rather than capital appreciation. Looking ahead, I don't expect this to change. In fact, if management's measurement of net interest margin is correct, the current yield on average interest earning assets (3.04%), net interest margin (1.54%) and leverage (~7) indicate a return on equity (and hence sustainable distributions) of about 12.3%, which is slightly below the 12.8% current yield. This very rough, back-of-the-envelope, calculation indicates that for distributions to be sustainable under current conditions, and assuming no reduction in the investment portfolio, they would have to be reduced from the current rate of $0.55 per quarter to ~$0.53 per quarter. Should this modest reduction occur and be accompanied by a sharp decline in share price, a buying opportunity may develop. As always, investors should perform their own due diligence and assess their individual tolerance for risk before buying or selling the shares.

Disclosure: I am long [[NLY]], [[EPD]], [[EPB]], [[WPZ]], [[PAA]], [[ETP]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also Annaly: How mREITs Make Money And The Case For A Dividend Increase on seekingalpha.com

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